Tuesday, April 24, 2007

The private equity revolution

Everybody's talking about it: the revolution of "going private" in U.S. business. It means publicly traded companies buying back their stock shares, or always-private companies never "going public" - starting to sell shares of ownership - in the first place. Why is it happening, and what does it mean?

There's always been a quiet countercurrent of private equity in American capitalism throughout the last century, which was loudly dominated by the publicly-traded stock revolution. Precisely because they're not publicly traded, you see and hear little in the conventional media about private companies. The big immediate stimulus to the current "counterrevolution" is the overburden of reporting requirements imposed on public companies by the Sarbanes-Oxley ("Sarbox") Act of 2002. The Sarbox law was passed in the wake of major scandal fallout from the excesses of the late 1990s. The most extreme and best-known of these corporate governance scandals - squandering and stealing investors' money, essentially - were those of WorldCom and Enron. Sarbox is classic political overreaction stimulated by saturation media coverage. It requires something analogous to everyone in the country filling out a stack of forms every three months to certify that they're not axe-murderers - after a few years of saturation coverage of Lizzie Borden made everyone hyperconscious of axe-murdering. The forgotten truth is that what the managers of WorldCom and Enron did before 2002 was already illegal many times over, and all of them are suffering various punishments on that basis.

The private equity revolution is investors' own reaction to the negatives of publicly-traded stock, separate from and in addition to the better-known regulatory reaction. And a surprising fallout from the new Democratic majority in Congress is that serious reform of Sarbox might be in the offing.

We take public equity for granted today, but in the long view of history, it's a strange institution that fits the realities of ownership and management poorly. Adam Smith, in the Wealth of Nations, firmly concluded then (in 1775) that separation of ownership and management of an enterprise was impractical. It exposes owners (investors) to the risk of having their investment mismanaged by other people (managers) who have shaky incentives to make proper use of investment money. In good times, investors would tend to lose interest and awareness of what was happening with the company they invested in. Managers would have an incentive to line their pockets and play fast and loose - it's not their money, after all. Smith didn't know about the modern media, but he would have quickly grasped the further bad side effects of anonymous public investment markets stemming from a investment public with limited knowledge and interest inundated with irrelevant or misleading information.

And so public equity remained virtually unknown until the middle of the 19th century. The emergence of national- and international-scale economies in the second third of the 19th century, with technological revolutions in communication and transportation, changed that. Large companies got much larger and required previously-unheard-of mounds of capital for their operation. No small group of owners could provide savings on this scale, and so modern equity markets were born. A useful date in this evolution to remember is the founding of the Dow Jones Company, parent company of the Wall Street Journal and Barron's, in 1882. From the start, modern equity markets were vulnerable to the problems Smith predicted. Periodically - at the turn of the century, in the 1920s, in the 1960s, then against in 1980s and 1990s - investment bubbles would appear and then burst, with serious consequences. A new type of scandal emerged - the corporate scandal - where managers would do something wrong, either by mistake or by design, with investors' money not their own. The major counterforces to these tendencies have been the growth of business reporting and the rise of governmental regulation. Both are good things - up to a point.

There's another factor that separation of ownership and management brought into play, one that Smith also anticipated, and that is the refocusing of corporate energy and attention on investors and away from both employees and customers. Many of the problems with modern corporations stem from this condition. The point of being in business is to provide customers with goods and services. (The point is not making a profit; that's just the reward, and also an indicator of doing something right.) Much of the lopsidedness of modern corporations - the practically instant creation of small groups of big winners in IPOs and overpaid executives - stems from their relationship to investment markets, not to customers. A company focused on customers tends to have power and responsibility spread throughout the organization. A company focused on investors tends to have power concentrated with the people who have control over the issuing of stock and debt and the privilege of frequent media attention.

Is the private equity revolution a good thing? Probably. The technology is there for small-scale enterprises to manage large amounts of information. But the main reason for small business failure is and has always been undercapitalization. So the question lingers: can privately-held companies generate the capital they need to stay in business and expand?

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